GAAP stands for Generally Accepted Accounting Principles. It is the accounting standard adopted by the U.S. SEC, and it encompasses a set of rules and requirements for reporting financial information to external parties that allows for easy, standard comparison across companies.
While these requirements are just that, requirements, and offer consistency across the board when viewing company information from an external perspective, the question arises: should these external reports drive internal decision-making? Do they show the detailed picture that organizational leaders need to make strategic decisions for their own company? No. As Debra Smith and Chad Smith state in their book Demand Driven Performance, “GAAP was not built or intended to drive decisions in its manufacturing and supply chain assets...” So why do so many organizations use it as the cornerstone of their internal financial assessments?
Great for the Past, Not Great for the Future
GAAP shows us past performance, but it does not accurately forecast future performance, especially as it relates to how costs will behave. With the constantly changing, complex environment that manufacturers exist in, using GAAP to forecast future unit costs is almost guaranteed to give your organization false expectations and lead to ill-informed decision-making.
Absorption Costing & The Cost-Minimization Mindset
GAAP utilizes absorption costing, which assigns all variable and fixed costs to products/inventory. While this is helpful for external reporting, when used as a guiding tool internally it creates mindsets that can be limiting for manufacturing organizations’ growth. One of these limiting mindsets is the cost-minimization myth, which is the false belief that minimizing unit cost is the clearest path to maximizing ROI. This mindset leads to organizations cutting costs everywhere (variable and fixed) in order to make their reports look better, but, in reality, this cost-cutting causes them to limit investments in improvements that would create a greater return for the organization, especially in the long-term. Like Debra Smith and Chad Smith outline in their book, Demand Driven Performance, other results of this cost-minimizing mindset and practice include “lower service levels, depletion of cash, inflation of inventory, and the squandering of resource capacity and materials.”
Managerial Accounting & MRP
The best solution to distance your organization from the pitfalls of GAAP-based decision making is to utilize managerial accounting practices to inform your organization’s decisions more so than financial accounting (I.e. GAAP). Managerial accounting is meant to be internally focused and can provide a much more accurate picture of performance and forecasting to drive your team’s decisions.
Perfect! A reasonable solution that most can understand and get behind. So then, what’s the issue? Over the years most organizations have reduced their management accounting capabilities in an effort to reduce management costs (ironic, right?). So, the financial information that is easily accessible (and already exists) for teams to use in decision making is, you guessed it, GAAP.
Not only that, but GAAP is largely integrated in most MRP and ERP programs’ financial capabilities. Financials were made a part of MRP programs in the 1980s and, similar to many parts of modern MRP and ERP programs, the rules by which it operates have not changed much since then. This means that it is difficult for most manufacturers utilizing MRP and ERP systems to create a new way of looking at financials that removes them from the pitfalls of relying on GAAP reports and allows them to experience significant future growth.
How Can You Be Different?
So the question remains: how can you differentiate your organization and fill in the gaps in GAAP?
First step: get out of the detrimental cost-minimization mindset and realize that investments in technology, especially technology with strategic, modern financial capabilities, can provide immense value for your organization in the short-term and long-term.
Second step: Don’t invest in just any program. Make sure your organization invests in a smart, forward-thinking MRP or ERP software built by a company who recognizes issues like those outlined above and actively works to solve them and position your organization for success. Repathis is that company, and Revive is that manufacturing software that will help your company move ahead of the pack and secure long-term success in this unpredictable manufacturing industry. Interested in learning more? Contact us here.